Real Estate Related Red Flags to Avoid on This Year’s Tax Return

As a real estate investor, your tax returns are more complex than an ordinary taxpayer. If you’re smart, you’re using a CPA to prepare your tax returns. A CPA can help ensure you get the maximum deductions allowed and to verify that all the information on your returns is accurate and categorized correctly. However, there are still some grey areas that aren’t always easy to identify. That and some other errors may raise some red flags that could trigger a tax audit. Since everyone wants to avoid this scenario, here is a list of real estate related red flags to avoid.

Not Claiming Income on a Rental Property

In order to claim a property as an investment and take the relevant deductions, you would need to charge fair market rent. You can rent to a relative if you like, but you still need to charge them rent and claim the income. Even if your needy nephew is a great kid who is still finding himself in the big city, he has to pay you fair market rent. But let’s say you have a big heart and your sister has asked you to cut him a break. Your generosity could cost you more than money. Not claiming income on a rental that you’re taking deductions on is a big red flag to the IRS.

Overstating Rehab Costs

Rehab costs are tax deductible. You can deduct the cost of insulation, siding, paint and a lot more. However, overstating your rehab costs in order to pad your deductions is a bad idea and will raise red flags. Unlike in some government agencies in the past, paying $250 for a hammer isn’t going to fly. The IRS has a lot of experience reviewing the tax returns of real estate investors. Eventually, they’ll catch on. Keep every single receipt you or your contractor collects and deduct only the exact amounts.

Inflated Property Expenses

Naturally, you have expenses related to owning a rental property. There’s the property manager to pay, the new faucet to pay for and maybe even the new washer for the garden hose; it all adds up. But to keep it from adding up to an audit, don’t try to inflate those property expenses. The IRS is on to investors who try that kind of thing. If anything, try to keep your ongoing property expenses within reasonable limits. And again, save those receipts!

Not Capitalizing Certain Expenses

If your CPA is doing your tax returns, you probably don’t have to worry about raising this particular red flag. Otherwise, be careful. There are certain deductions that you can take in full. Others, such as property improvements (as opposed to property repairs), need to be depreciated over a certain number of years. Make sure that you’re doing this to the best of your ability. A general rule of thumb is that if the expense is a one-time repair, it’s fully deductible. If the expense is something that adds value to the property or extends its life, it should be capitalized. Ask your CPA whenever you’re in doubt.

Eric Martel is not a CPA, nor is he a tax professional. The tips given above are based on personal and professional experience. You should seek the counsel of a licensed CPA for all tax-related issues.